Should you pay down your credit card or car loan before you apply for a mortgage?

By Michael Jensen, Mortgage and Finance Guru

Edited by Harry Jensen, Trusted Mortgage Expert with 45+ Years of Experience

Updated October 20, 2020

In most cases, I recommend that you pay down your credit card debt instead of a car loan before you apply for a mortgage. This approach typically saves you the most money and increases the mortgage you can qualify for.

Credit card debt usually carries a much higher interest rate than a car loan so it makes more financial sense to pay off higher cost debt before moving on to debt with a lower rate. By paying off the more expensive debt first, you reduce your total interest expense.

Additionally, reducing your credit card utilization rate while keeping your account open can have a positive impact on your credit score, which is beneficial when you apply for a mortgage. Simply put, the higher your credit score, the better your mortgage rate.

Another point to consider is that your monthly credit card payment is calculated based on your outstanding account balance -- the lower your balance, the lower your payment. If you can pay down your credit card by a sizeable amount, you can significantly reduce your monthly payment.

Including a lower credit card payment in your debt-to-income ratio increases the mortgage you can afford. In short, the lower your monthly debt expense, the more money you can spend on your mortgage and the higher the loan amount you qualify for.

Use ourMORTGAGE QUALIFICATION CALCULATORto determine the mortgage you can afford based on your income and debt

In comparison, a car loan usually amortizes based on a fixed interest rate which means your required monthly payment does not change regardless of your loan balance. Paying down a car loan still saves you money and enables you to pay off the loan faster but does result in a lower monthly payment or improved debt-to-income ratio.

For example, if your monthly car loan payment is $500 and your current loan balance is $7,000, your payment remains $500 after you pay down half of the loan balance to $3,500. You reduce the number of payments you are required to make but your payment stays the same.

This means that paying down an amortizing loan such as a car loan may have less of an impact on your mortgage qualification. Returning to the example above, the same $500 car loan payment is included in your debt-to-income ratio even when you cut your loan balance in half so the mortgage you can afford does not necessarily change.

If you had used the funds to pay down your credit card balance instead, your total monthly debt expense is lower which increases the mortgage you qualify for.

While it usually makes more sense to pay down your credit card before a car loan, there are several points to keep in mind that impact the decision. First, monthly payments on amortizing debt such as a car loan with less than six months remaining in the loan term are typically not included in your debt-to-income ratio when you apply for a mortgage.

So if you have less than six payments remaining on your car loan then it does not make sense to pay down the loan because those payments are already excluded from your debt-to-income ratio. From the lender’s perspective it is as if the car loan does not exist.

If you have more than six payments remaining on the car loan but you can reduce the loan term to six months or less, then it may make sense to pay down the loan instead of your credit card. In this scenario you should determine if paying down the car loan or credit card reduces your total monthly debt expense more and pay down that debt first.

We should also highlight that if you pay off your credit card completely, some lenders include an estimated monthly payment for the account in your debt-to-income ratio even though the balance and required payment are zero. This approach partially diminishes the benefit of paying down your credit card.

The table below shows mortgage terms for leading lenders in your area. We recommend that you contact multiple lenders to confirm the loan you qualify for.

In summary, if you are deciding between paying down a car loan or credit card, determine the option that reduces your total monthly debt payments the most while taking into consideration the interest rates and lengths for both loans. Doing this should improve your ability to qualify for a mortgage and save you money in the long run.

Sources

"B3-6-02, Debt-to-Income Ratios."  Selling Guide: Fannie Mae Single Family.  Fannie Mae, February 5 2020.  Web.